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U.S. Federal Reserve: Ending the year with a target interest rate range of 4.25%-to-4.50%

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Key messages

  • The target range for the federal funds rate was increased by 0.50%.
  • Inflation remains high and short-term inflation expectations remain elevated.
  • The Fed expects interest rates to go higher in 2023.

Once again, members of the Federal Open Market Committee unanimously voted to increase the target range for the federal funds rate. The 0.50% hike brings the U.S. Federal Reserve’s (Fed) target interest rate range to 4.25%-to-4.50%, its highest level since 2007. As a reminder, the Fed has raised its target range by 0.75% in its last four policy decisions before the most recent move. So technically, the Fed has slowed the pace of its rate hikes. The change was widely anticipated by market participants as was the Fed’s announcement to also continue to lower its holdings of treasury securities, agency debt and mortgage-backed securities.

The Fed also repeated that it “anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2.0% over time.” This coupled with higher expected interest rates for 2023, 2024 and 2025 versus what was projected in September, upset equity markets on Wednesday (December 14th, 2022) afternoon.

The Fed expects rates to go higher

Along with the announcement, the Fed also published updated economic projections. Most notably, inflation expectations were revised up to 5.6% in 2022 (from 5.4%), 3.1% in 2023 (from 2.8%), 2.5% in 2024 (from 2.3%), 2.1% in 2025 (from 2.0%), before reaching 2.0% longer term. This has pushed expectations for the median federal funds rate to 5.1% in 2023 (from 4.6%), 4.1% in 2024 (from 3.9%) and 3.1% in 2025 (from 2.9%). The Fed remains steadfast in its commitment to returning inflation to its long-term 2.0% objective. Economic growth was revised up to 0.5% in 2022 (from 0.2%), down to 0.5% in 2023 (from 1.2%) and down to 1.6% in 2024 (from 1.7%).

Drivers of inflation remain

Taken from the Fed’s announcement, “recent indicators point to modest growth in spending and production. Job gains have been robust in recent months, and the unemployment rate has remained low. Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher food and energy prices, and broader price pressures.” Additionally, regarding the invasion of Ukraine, “the war and related events are creating additional upward pressure on inflation and are weighing on global economic activity.”

Policy decisions remain in line with our expectations

In our portfolios, we recently increased our allocation to equities overall and moved to a neutral position relative to fixed income (modestly overweight) and cash (modestly underweight) as risks to global markets have become more balanced. With that said, the global economy still faces challenges due to the lagged impact of more restrictive financial conditions as inflation remains stubbornly high – this will prevent policy makers from easing up on higher interest rates and will keep near-term risks of a recession elevated. However, we have already seen significant declines and do not expect markets to fall materially.

Within equities, we rotated a modest allocation from Canadian (modestly overweight), U.S. (modestly overweight) and international equities (underweight) back into emerging markets. We are now neutrally positioned in emerging markets as China has taken steps towards easing pandemic-related restrictions.

On the fixed income side, we continue to target a flatter yield curve (longer-term bond yields to decline by more than shorter-term bond yields) and a slightly long duration (interest rate sensitivity) bias in North America.

For more information about this announcement or your portfolio, please contact your MD Advisor*.

If you are wondering how rising rates will impact your finances beyond your investments, here’s what it could mean for you.

The Fed’s first interest rate announcement for 2023 is scheduled for February 1st.

* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec), or an MD Private Investment Counsel Portfolio Manager.

The above information should not be construed as offering specific financial, investment, foreign or domestic taxation, legal, accounting or similar professional advice nor is it intended to replace the advice of independent tax, accounting or legal professionals.

About the Author

Richard Schmidt, CFA, is an Associate Portfolio Manager with the Multi-Asset Management Team of 1832 Asset Management L.P. His primary focus is MD’s North American equity funds and pools.

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